PARIS, July 23 (Reuters) - European stocks sank on Monday, with a key blue-chip index tumbling to a three-week low and piercing through a major support level, hurt by mounting fears that Spain could soon become the fourth euro zone member to request a full bailout.

A ban on short selling unveiled by the Italian and Spanish market authorities helped limit the damage on local stocks, but it was not enough to reverse the overall negative trend across European markets, where trading volumes were brisk.

“We’re moving closer to the cliff, the systemic risk is just going up but it seems that it will take a major event such as a bank failure or the Greeks saying they want to leave the euro zone, before we get real decisions by the EU leaders,” Saxo Bank head of equity strategy Peter Garnry said.

“As long as there’s no ‘meeting of the EU cardinals’ and no bold decisions on the future of the bloc, things will just worsen.”

Spain’s central bank said on Monday the economy sank deeper into recession in the second quarter, fuelling fears the country’s funding crisis could quickly accelerate and force it to request a full bailout.

BAN ON SHORT SELLING

During market hours on Monday, Spanish and Italian market regulators reintroduced bans on short selling in a bid to discourage speculative trading following a two-session sell-off in stocks.

The move helped the two countries’ main stock indexes trim their losses, with Madrid’s IBEX ending down 1.1 percent after losing as much as 5.5 percent and Milan FTSE MIB ending down 2.8 percent after losing as much as 5.2 percent.

After the closing bell, France’s AMF stock market watchdog said it would not follow the move to reinstate the short selling ban, saying it was not justified at this stage.

“The last few times we’ve had short-selling bans, we’ve seen the market go down,” said Toby Campbell-Gray, head of trading and risk at Tavira Securities.

“It takes liquidity out of the system, and it just shows that the powers that be don’t understand how markets work,” he said.

Data from Markit, a provider of financial information services, shows that short sellers have not been targeting Spanish or Italian banking stocks.

Only 3.1 percent of the outstanding shares of Banco Santander are out on loan, while the average on the IBEX is 4 percent, data shows. Italy’s UniCredit has 1.1 percent of its shares out on loan, compared with an average of 2.7 percent for the FTSE MIB.

The Euro STOXX 50 is down 17 percent since a high hit in mid-March, dragging its 12-month forward price-to-earnings ratio to 8.8, well below a 10-year average of 11.3.

But despite the relatively cheap valuation levels, Saxo Bank’s Garnry warned ratios in the current market environment are not as useful for investors as they used to be.

“Earnings have been pretty resilient, but that’s not what’s driving the market. Asset prices are essentially following the perceived tail risks. Spanish and Italian stocks look very cheap, but when you buy them, you’re also buying a currency risk: what if the euro zone breaks down?” he said.

“It makes no sense to use valuation levels to make investment decisions at this point. You can’t just bet on mean reversals, there’s too much uncertainty about the outcome of this crisis.” (Reporting by Blaise Robinson; additional reporting by Sudip Kar-Gupta in London; editing by Ron Askew.)